Joachim Fels (PIMCO): lower US interest rates could be a drama

By Joachim Fels, PIMCO global economic advisor

“Then the phone rang.” This is the last sentence of The Undoing Project by Michael Lewis, and I recommend that you also read all the other sentences in this book. It’s the story of the friendship between psychologists Amos Tversky and Daniel ‘Danny’ Kahneman, whose path-breaking joint work about how the human mind errs systematically when forced to make decisions under uncertainty revolutionized not only psychology, but also medicine and economics. Of course, the phone call came from Sweden to inform Danny in Princeton that he had been awarded the 2002 Nobel Memorial Prize in Economics for his work with Amos, who had died aged 59 in Stanford six years earlier. It was the first time that the prize in economics went to a psychologist.

Reading The Undoing Project last weekend ahead of PIMCO’s Cyclical Forum on Monday served as a useful reminder of the many cognitive biases that Kahneman and Tversky identified as guiding people’s judgment and predictions. People’s (including experts’) decisions are often guided by simple rules-of-thumb, or ‘heuristics’, that lead to systematic deviations from probability or rationality. Well-known biases include the “anchoring bias”, the “recency bias”, the “availability bias”, the “hindsight bias” and the “confirmation bias”. Being aware of the biases that rule our thinking is a first step towards making better predictions.

Speaking of predictions, at our December forum, we deliberately refrained from making bold predictions about the economy and markets over our cyclical (6-12 month) time horizon. We rather acknowledged the radical uncertainty about what kind of policies the incoming Trump administration would pursue and how other players (China etc.) might react to it. In the cyclical outlook essay Into the Unknown published after the forum, we concluded that the distribution of macro outcomes had fatter tails than usual and discussed three possible scenarios for this year’s macro economy based on different assumptions on political and economic policy developments. The natural conclusion was to respect the uncertainty and remain patient as investors until we have more clarity on the path taken, rather than taking big directional bets one way or another.

In many ways, though not in all, this turned out to be the right decision. U.S. Treasury yields, which had rallied sharply post-election have been bumping broadly sideways since our December forum. The U.S. dollar, which had also rallied sharply and looked like a one-way bet to many investors in December, peaked in late December and has since given back some of the earlier gains. Crude oil prices jumped from $45 to $55 per barrel after the election but have gone nowhere since. EM high-yielding currencies such as the Brazilian real, which had sold off sharply initially in the fear of protectionist U.S. policies, resumed their gradual appreciation.

However, what has been surprising (at least to most of us) has been the relentless rally in U.S. equities and the further fall in actual and implied volatility in the face of elevated and continuing uncertainty about the policy outlook. It seems as if investors have been entirely focused on the fatter right tail of the distribution of outcomes while ignoring the fatter left tail. Or are they right in doing so? This is just one of the many questions we will be debating this coming week.

Some other obvious topics that we’ll dive into at the forum include the likely shape and timing of Trumponomics, the future of Europe in the face of Brexit and the important upcoming elections, and the risks emanating from China’s credit bubble and capital outflow pressures. As usual, we will publish our conclusions later this month. Stay tuned.

Here are three further questions that are on my mind given the economic and monetary policy developments since our December forum. I don’t have good answers, only some tentative hypotheses, so any hints you may have would be welcome.

First, why is it that just at the time when everybody talks about de-globalization, global trade volumes have rebounded vigorously in recent months. True, we are witnessing a more synchronized global recovery driven by the manufacturing sector, and within that particularly in energy, but the extent of the rebound is still surprising. Is this only temporary and perhaps exaggerated by the expiration of car sales incentives in China, or could we be at the cusp of an even more powerful synchronized acceleration of global growth and animal spirits this year?

Second, why has core inflation remained so dormant in most of the advanced economies despite buoyant labor markets and the above-consensus acceleration in headline inflation? Is there more slack in labor markets than meets the eye? Is the fear of digitalization- and artificial intelligence-induced future unemployment so high that workers acquiesce? Or are inflation expectations so firmly anchored after many years of inflation undershoots that slack (or the absence of it) simply doesn’t matter any more?

Third, but not least, what caused the sudden change of mind at the Fed over the past week or two from sounding patient and not in a rush to hike rates to telling markets in no uncertain terms that a rate hike in mid-March will, in both Lael Brainard’s and Janet Yellen’s words, “likely be appropriate”? Are policy makers just swayed by the equity rally and the rise in soft sentiment indicators, despite a lack of convincing evidence that the hard data are following suit? (In fact after this past week’s data, first-quarter GDP is tracking somewhere between 1.5% and 2% after an unexciting 1.9% in Q4). Or are they making a bet on future expansionary fiscal policies by the Trump? And if so, what has happened recently that makes this more likely than a month or two ago?

I don’t know what the reason for the change of mind at the Fed is, and I resist the temptation to make it seem obvious and logical after the fact (“hindsight bias”). My best guess is that the Fed is in “opportunistic tightening” mode: still worried about the lack of distance to the dreaded zero lower bound for interest rates and happy to opportunistically exploit the hand dealt to them by buoyant equity markets and confidence indicators to increase that distance. But again, I’m just guessing.

Call me chicken, but here’s my concern: Didn’t we learn in recent years that the global financial cycle depends on U.S. interest rates and the dollar given the mountain of dollar debt accumulated in the rest of the world? Of course, 25 basis points is small change, but if markets take the Fed’s recent change of mind as a sign of a new, more aggressive reaction function and push U.S. yields and the dollar significantly higher in response, we could be in for some “carnage” in the rest of the world. Yet, this is just my personal view, which like many others’ theses and predictions will be up for thorough scrutiny and debate at our forum.